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Living with capitalism: macro-economic policy alternatives

First published in Renewal volume 2, number 1 (1994), pp. 47-60

Labour should adopt an economic strategy that places the supply side at its centre with Keynesian policies as a support.

The media will only believe that Labour has a macro-economic policy if it says something bold, dramatic, clearcut and totally contrary to the Conservatives in every respect. To some in the Party very similar criteria are used. So current policies are condemned by media and activists alike as weak and inadequate. This is no sensible way to argue about policy options.

In the end we have to present actual policies to the public and a key element of the role they must play is indeed in showing how we differ from the Conservatives. But in determining these policies we must go beyond attacking and proposing the opposite of the Tories, or just revealing our latest prejudices and pet theories. Today, a familiar battle is taking place over macro-economic policy in the rather confusing post-ERM era. As before, although the attacks on current policy are to a degree based on genuine differences of opinion about appropriate economic policies, much of it appears to be part of a general dislike of the perceived lack of assertiveness and boldness of the Party leadership (see Hain, 1993). Such coded debates using macro policy as one of the drums to beat out the main theme, do not help in establishing a viable policy. There will always be plenty of room for disagreement but if these can be debated with some sense of structure, the Party is less likely to find macro policy something that it splinters apart on.

What is macro policy?

Macro-economic policy tries to alter things such as unemployment, inflation, growth, the trade balance or overall investment. In general, macro policy tools try to do this by altering demand in the economy, rather than supply. The tools include both fiscal and monetary ones — public spending, the overall tax burden, the money supply, interest rates and the exchange rate.

Of course, all economic policy is in a sense about things such as unemployment and growth, but macro policy tries to act on them directly. It is associated with pulling simple levers at a central level with effects on everyone and does not concern targeted and detailed intervention. Improving management training to get firms to produce more competitively is micro-economic (or supply-side) policy. A change in income tax rates is macro, but a tax-break for investing in the inner city is micro. Changing the interest rate is macro-economic: regulation of utilities is not. To the extent that an economy in aggregate is simply the sum of its sub-markets, there is clearly massive room for overlap and we should not worry too much about exact boundary lines.

Points of agreement

There are several different approaches on the left to what macro policy can and should be used for. But the common belief in the ultimate purpose of such policy dominates the differences on techniques for achieving it. The key thing about a Labour macro-economic policy is that it is aimed at achieving particular 'real' goals, where Conservatives use macro policy as an arm of their free-market philosophy.

Under the Conservatives since 1979, macro policy has been aimed primarily at achieving monetary stability (primarily low inflation) so that the market can work to best advantage. While the method has varied (controlling the money supply, using high exchange rates and now inflation targets), the main strategy has not. Nigel Lawson spelled out most clearly in his 1984 Mais speech that macro policy was to control what are known as nominal variables and nothing else: supply-side policy was the key thing: 'It is the conquest of inflation and not the pursuit of growth and employment, which is or should be the objective of macro-economic policy'.

His recent biography amplifies the point: 'The key is to abandon the attempt to set 'real' targets — objectives for real economic growth, full employment or whatever — and instead to define objectives in money terms' (Lawson, 1992). For Tories, of course, supply-side policy means freeing up the market via deregulation, lower marginal tax rates and privatisation. This is diametrically opposed to the active government view of the left. If pushed, Conservatives would say that in this way they were dedicating macro policy to the same things as Labour (such as growth), but this came very much second to the aim of freeing up the market.

In principle, every person on the left should disagree with this. The objective of all economic policy, macro or micro, must be explicitly about growth, employment generation, equality and so on. As John Smith said at the 1993 Party conference, all instruments of economic policy must be geared towards these ends. To some the acceptance of this philosophy makes the policy that he developed for the last election look absolutely daft. Wasn't the policy dominated by the commitment to ERM? Didn't that mean that macro policy instruments had been given up as a tool of policy? If only life were so easy to interpret!

How does macro-economic policy work? Four different approaches

There are broadly four schools of thought on the left on the technical issue of what macro policy can deliver and therefore how it should be used (see Table 1).

Table 1

(View 1)

Supply Siders

(View 2)

Active Macro

(View 3)

Strong Keynesian

(View 4)

Supportive Keynesian

Macro policy effective?

No

?

Yes

Yes

Macro policy has long run effects?

No

No

Yes

Yes?

Demand the most important thing?

No

No

Yes

No

Stability in macro the key?

Yes

Yes

No

No

Active macro policy?

No

Yes

Yes

Yes

View one essentially says that macro policy at the national level can have little effect. This argues that macro-economic conditions can have profound effects on performance, but denies that government today has much influence on them. World forces are simply too powerful for single countries (particularly small ones), to counteract through their own macro policy.

Similar policy conclusions are reached by those who believe that in the long run macro factors have little effect on economic performance and only supply ones do. In either case, the concentration for rational economic policy should be on the supply side and one may as well go for as stable a macro policy as possible so that tax rates, public spending and the exchange rate are held relatively steady to minimise uncertainty. Add to this a belief that supply-side policies work best in conditions of macro-economic stability and you are close to the policies of 1992 — what I will term the supply-siders.

A second view, related to the above, but with diametrically opposite conclusions, is one that argues that the achievement of some sort of stability in macro performance is essential but that this requires active macro policy. Capitalism inevitably churns out booms and slumps and only countervailing 'fine-tuning' can give the stability and confidence in which the supply side can work. But it is still the latter that really counts. This is a fairly Keynesian view but only to achieve stability and smooth the business cycle.

The third, strongly Keynesian view, is that associated in debate (rightly or wrongly) with Bryan Gould, namely that altering factors such as exchange or interest rates can have large and profound effects on real activity and aggregates even in the long run. From this perspective active macro policy is essential and all levers must be kept available. For strong Keynesians getting demand policies right is the most important thing about economic policy and they often show frustration at too much attention being given to the supply side. They are prominent in opposition to Maastricht, which they take to limit the power for demand management (Burkitt et al., 1993).

The fourth view, and perhaps more fairly one that should be ascribed to Bryan Gould and his supporters, is that macro policy should be the servant of supply-side policies, but that this means more than engineering stability. As put in a collection of essays coming out of Bryan Gould's work for the Policy Review, 'macro-economic policy should be designed to support the industrial supply-side strategy' ... [and quoting the 1989 Policy Review] 'We shall therefore change the balance of that policy in favour of wealth creators rather than the holders of assets' (Neuberger and Sawyer, 1990). For these supportive Keynesians, this particularly means a low or 'competitive' exchange rate and low interest rates and is often characterised by a belief that overvaluation of the exchange rate has been the major problem for British industry and trade for years.

To believe, therefore, that macro policy should be dedicated to growth and low unemployment tells us little about what we do with it. For example, if one believes that exchange rate stability is crucial to private sector investment and trade, that exchange rate devaluation has historically failed in the long run and that one’s most powerful neighbours are going to move towards a single currency, then the best thing might well be to be rather dull on macro policy. Hence, a policy of joining the ERM and signing up to EMU. If, however, one believes exchange rates powerfully affect the trade balance, easing constraints on expansion towards full employment and that capital or exchange controls can isolate an economy so that in the medium term an independent monetary policy for the UK is actually possible, then joining a fixed exchange rate system appears to be crazy and a betrayal of everything Labour believes.

All of this illustrates that there is not and cannot be a 'left' Labour macro-economic tool as opposed to a right-wing Labour or Conservative one, or at least in the way that there clearly is on the supply side. The key is to make sure we are trying to hit socialist objectives, taking account of all the constraints faced at the time.

Labour lurches

Perhaps typically, Labour macro-economic policy thinking has lurched between the extremes of these four approaches. The process involves fierce resistance to new ideas and beliefs leading to bitter struggles to change policy and then an equally conservative and protective approach to wherever that has landed us.

If one goes back to the 1960s and early 1970s then the policy can crudely be described as demand-fixated. Reflecting the naive Keynesian thinking of the time, there was a belief that if demand in the economy was at the right level, then all else would be solved: 'there is a question about what macro-economic policy, however well designed, can achieve. A naïve answer from the 1960s might have been "almost everything"' (Allsopp, 1991).

The important and enduring insight into a capitalist economy at the macro level — that it cannot automatically deliver appropriate levels of demand and can get stuck in an unemployment equilibrium that only government demand policy action can rescue it from — turned into a universal nostrum for managing an economy. The implications were enormous. Supply in the economy (of goods made by firms, of trained and educated workers, of R&D facilities) was largely ignored. Implicitly — or even explicitly — it was believed that demand would create its own, appropriate supply: even those who tried to emphasise planning in the early 1970s appear to have been motivated more by a desire to achieve efficiency than by a fear of the weakness of aggregate demand alone to deal with unemployment (1). Inflation was therefore not taken too seriously as a constraint on growth until it went out of control. Even then, the focus remained firmly on demand policy, with incomes policy used to try and avoid the nasty side effects.

While the parliamentary leadership began to turn away from demand management — with Jim Callaghan's conversion from the ideas of spending one's way out of trouble — a strongly Keynesian message continued to dominate the Party in the form of the Alternative Economic Strategy (AES) (2) which called for, 'A policy of expansion aimed at restoring full employment and raising living standards, based on a planned reflation of the economy primarily through increases in public spending' (CSE, 1980). Import tariffs and controls in a siege economy were advocated to deal with the trade problem. Price controls were put forward to deal with inflation and extensive public ownership was also called for.

This policy began to change over the first half of the 1980s. The major spurs were undoubtedly the regular loss of elections, and the failure of Mitterrand's attempt to solve unemployment in France through demand expansion in one country. However, intellectual currents played a role too with extreme arguments that demand management could have no effect beyond the short run (the New Classical Macro-economics) taking some hold on the economics profession (Sergent and Wallace, 1976).

But progress was slow, and as late as 1987 policy was still largely Keynesian in character:

We will reduce unemployment by one million in two years as the first installment in beating mass unemployment ... we will pay for them by ... prudently borrowing £3bn for useful wealth-generating national investment. (Labour Manifesto, 1987)

However, by 1992, to many people's horror, the policy had shifted markedly. A macro dimension seemed to have been given up as Labour went overboard on supply-side issues. Arguably, the fixation with demand had been replaced by a supply-side fetishism as the ERM was embraced, fiscal expansionism resisted, and training and education took top billing. From a situation where the feel was 'look after the short term and the long term will take care of itself', we now had a policy that was long-term in nature with relatively little to say about demand and the short term.

So what do we do now? Is it time for a lurch away from the supply siders' route? Now that the ERM is gone, are we all 'strong Keynesians' now? At any particular time we do have to choose one or a combination of these policies: they cannot all be followed at once. But the key is to be flexible and focus on objectives. The fact that a whole raft of things made the 1992 policy appear appropriate (a priori at least) — the state of world economy, public opinion, the apparent rush towards EMU by the rest of Europe — this does not make it wrong to change now.

Means and ends

Like so many areas the purpose of Labour's macro-economic policy constantly becomes confused with the means of achieving it. At one stage in the early 1980s the AES became held up as a bible by sections of the Party and to be against it was to be a right-wing revisionist. In the early 1990s, support for the ERM became essential if one wanted to be thought of as solid and serious about winning elections. They all represented strategies for coping with the need to manage the capitalist economy towards our objectives.

But the truth is that economics cannot give blueprints for action that deliver particular outcomes: while it loves to pretend to be a science, economics is a social science — it is about people. And human behaviour is unpredictable. The left has a unique understanding of the shortcomings of market forces which tells us that, left to themselves, economies under-invest, generate income inequality and destroy the environment. But this tells us precious little in itself about what macro strategy is best to correct it.

Public opinion too, a key input to rational policy-making, is often in the thrall of particular economic ideas. General support for reflationary action in the 1950s and 1960s has given way in the 1980s to agreement with Mrs Thatcher that a nation, like the mythical housewife, cannot spend more than it earns. However misinformed these ideas are, policy setting without regard to them is doomed to failure at the ballot box.

What do we want to achieve?

While many of the macro arguments are technical, lurking behind some are differences in objectives and the trade-offs between them. Clarification is needed here too. Our primary objective with macro policy at present must be the delivery of sustained, non-inflationary growth: the objections to this are simply not strong enough. Some on the 'strong Keynesian' wing argue that the urgency is to get growth going: we can worry about whether we can sustain it when we get there. This would imply extensive and immediate expansion of demand. Yet to the extent that people's 'wellbeing' can really be gauged it is clear that uncertainty is almost as big a problem as bad times (and remember the political resonance of the fact that while 3 million are unemployed, 25 million are in employment). Dashes for growth always lead to the brakes going on hard further down the road.

More particularly given the current situation, should not full employment be our major objective and not growth? This is a tricky issue and we will want to emphasise the latter in presentation. But while we will want to make growth as labour intensive as possible, most of the policies to provide that will be micro-economic — how growth is divided up — and not macro. There is in fact no necessary contradiction here. Lurking behind the case for going fast for growth and full employment, rather than worrying about sustainability, is a different weight being put on other objectives. In particular, it is clear that many on the stronger Keynesian side of the fence are more relaxed about inflation.

We do value low inflation per se less strongly than the right wing because we tend to see it as a constraint on growth not an end in itself. If we were to discover decisively that higher sustained growth could only be achieved with higher average levels of inflation, then we would have only a weak case for being so concerned with inflation at all. However, at present the evidence for such a statement is fairly tenuous. There is a strong belief that higher levels of inflation tend to accelerate — and so lead eventually to counteracting deflationary policies. Furthermore, the public are hostile to high levels of inflation even if they are stable, however irrational that may seem.

On a different tack, it should be noted that people increasingly argue with the idea of growth as the objective:

Today's universal focus ... on maximising ... GDP-measured growth steers societies towards policies that make these macro-economic statistics look 'good' ... while short-changing every other aspect of progress, wealth, satisfaction and quality of life. Social and environmental costs of dealing with effects of such economic growth, whether unemployment, homelessness, poverty, crime, drugs, broken families, shuttered small towns, or cleaning up pollution are added rather than subtracted from GDP. (Hazel Henderson, 1993)

But while accepting the force of this argument and being aware that other indicators beyond GDP must be observed to get a fair picture of the extent to which a growth in GDP is actually increasingly 'welfare', it has to be recognised that we have no other current and universally recognised comprehensive measure.

Some options are just not on at present given our understanding of the way the economy is working and the political context. Here we begin to judge between the four views.

The problems of strong Keynesianism

For some the major impediment to decent macro-economic policies appears to be a lack of political will. A more realistic vision will face the constraints square on and try to build policies that take account of them. First, though few would argue that a major portion of current unemployment is due to too little aggregate demand in the economy, recent analyses would question how far this might take us. Some economists still stress supply-side factors, so that once we have reduced unemployment that far demand policies will only produce inflation (Wren-Lewis, 1994; Carlin and Soskice, 1990). In addition, there is work focusing on the fall-off in jobs for unskilled male workers which is said to reflect a structural shift in demand for skills and not a lack of demand in total (Gregg, 1993; Balls, 1993). Again, solutions are all about supply-side policy.

Second are the economic constraints on macro-economic policy. The increasing power of international capital both in the form of transnational firms and massive currency movements is best known. Also widely understood is the problem of trade deficits and of inflation that put limits on the degree to which macro manipulation in itself can achieve things. Differences in opinion on the degree to which these forces exist and can be overcome are legitimate, but all put serious question marks over macro strategies geared to strong Keynesianism.

The link to inflation remains key for a left macro-economic policy. As noted, stability oriented policies implicitly put a cap on the potential inflation we would tolerate: the 1992 commitment to the ERM was in a sense an implicit incomes policy and the inflation issue was noticeable by its absence. For those who want low exchange and interest rates at all times, other ways of dealing with inflationary pressures must be found. To the irredeemably optimistic, growth lowers unit costs and so puts downward pressure on inflation in itself. More generally it means that those advocating strong Keynesianism must be open in advocating incomes (and/or price) policies of one form or another to overcome this constraint and that has big problems in itself.

Third are the problems of active macro management. It is often hard to tell where the economy is, let alone where it is heading, and economic forecasting is often way off.

Furthermore, different macro policy instruments work with different degrees of effectiveness at different times and it is hard to tell how they will work a priori. Shocks constantly hit the system, be they unexpected changes in behaviour (people decide to save less) or oil price hikes. Finally, a totally discretionary policy can be difficult to operate in practice. Let's say that we have decided that a fixed exchange rate is one of the best policies at the time to achieve our objectives. If the markets sense we will not stick to it, then we are unlikely to be able to sustain the policy. All of this makes any kind of active policy at the degree of fine-tuning very difficult.

The problems of overdoing the supply-side message

The analysis so far certainly gives strong grounds for downplaying the case for over-active or strongly Keynesian macro policy in 'normal' times and for the belief that supply-side policies are more fundamental. Intuitively it is far easier to understand the idea that the success of a nation depends on its ability to produce high quality products efficiently and effectively than it does manipulating a price (be it an interest rate or an exchange rate) or aggregate demand. As various commentators have pointed out, the UK has tried numerous types of macro policy over the last thirty years, yet its declining world position has hardly altered.

At the last election, Keynesian style policies were largely ignored. There were good arguments for such a strategy at the last election — many of which have little to do with economics — but should we continue with the supply sider's heaven? First, in a recession where there are unused resources it is clear that aggregate demand is too low. There simply is no supply constraint and there is little danger of inflation taking off. In this case macro policy can undoubtedly be very effective and should be used boldly.

Second, to make too deep a distinction between demand and supply, macro and micro, is a major mistake. For instance, a strong belief on the left is that investment (supply) is good and consumption (demand) is bad. To raise investment it is agreed that we need macro policies to restrain consumer spending. But this may be over-simplistic. Private sector investment takes place because of an expectation of future demand — and that means consumption. The proper demand policies can therefore influence supply and a split between the two may thus be misleading.

Third, and related, there is a great deal of evidence that the situation of an economy in one period has profound effects on its performance in the next. If unemployment is allowed to rise too high due to inadequate demand, then the level of unemployment consistent with stable inflation rises. If a recession leads to capacity cutbacks, then the potential output of the economy falls. If firms are expanding in response to positive demand then they are more likely to invest in new technology. All this means that the supply side can be very much affected by inappropriate demand-side policies.

Fourth, supply-side policies take too long and are too indirect in their effects to make a complete strategy. The Lawson boom of the 1980s showed just how quickly a surge in demand can effect employment and growth (in this case as a consequence of financial deregulation and tax cuts). Supply-side policies can never promise this. They also depend on the private sector to deliver, which makes progress sometimes difficult and opaque. The very directness of Keynesian policies means they should be kept open as a possibility.

Politics

The last element in choosing which strategy to follow is to try and gauge where public opinion stands on the issue. To many Labour activists, macro-economic policy has the potential to transform our economic prospects. But to most voters, the idea that in the face of multinationals, currency speculation, and the new competition from East Asia, government can really transform economic performance by fiddling about with things like aggregate demand and the money supply seems incredible. It's how firms are doing that matters and government’s main role — if any — is to assist firms to produce more efficiently.

This gives the advantage to the supply siders, for people will not believe a party that tells them that they have a set of macro policies that can produce miracles. However, if a party of the left has any meaning, it is that we believe that purposeful government action can make things better. Indeed this is the message we give in all other areas. To say therefore that the best strategy for government on macro policy is to sit on its hands is bad politics, whatever the economics.

The way ahead

The above analysis leads to a view that what we need at present is a mix of supply-side and supportive Keynesian policies. The policy followed in 1992 is not the right one for the next election, but a move right over to strong Keynesianism would be a mistake. The key political and economic difference between the left and right will always be about the supply side. Government must act purposefully — on training infrastructure, R&D, education, small firms, transport, housing. As graphically illustrated by similar splits in both parties over the ERM, macro policy is more about tactics.

But we do need to add demand-oriented policies, both because they are right for an economy way below potential output and because they show that things are possible, thus attacking the sense of despair and fatalism in the electorate that never helps Labour. However, there are problems in shifting to a more Keynesian view, particularly since it often means increases in public borrowing. As Labour's pre-election polling showed strongly, people today are suspicious of this and the Tories never hesitate in exploiting the fact. This means that we need a new presentation of the idea of borrowing — making clear that the borrowing is for investment, and stressing the good return the nation can make on it rather than pushing its beneficial effects on aggregate demand. However, if we switch away from pure supply-sideism then we cannot avoid the borrowing issue, as we could at the last election.

Dissonant voices

In general, this is indeed the way policy seems to be heading. Rightly, the policy has shifted back a little, particularly since the 1993 Party conference, towards a more Keynesian feel with concepts of full employment and investment for growth now mentioned much more often (Brown, 1993). However, there remain two dissonant strands bubbling around among activists, both in their own way responses to the collapse of the ERM. In the first place, increased opposition has been voiced to Maastricht and the general trend of policy that it implies. Strong Keynesians have always been against this partly because of its embodiment of a fixed exchange rate policy, but also because of the provision for an independent central bank, and restrictions on budget deficits.

They are probably correct in this. However, other readings of Maastricht suggest that it would not itself rule out Keynesian policies. Exchange rate policy is a problem. Many would hope to keep the exchange rate as a relatively flexible tool, especially after the painful ERM experience, even if one does not believe much in the power of the exchange rate weapon. This indeed would be the logic of the supply-side/supportive Keynesian approach I have advocated. However, the ideal 'supportive Keynesian' policies may be hard to enact. Calls for returns to fixed but adjustable rates — along the lines of early ERM — are in fact difficult to deliver in the face of the powerful foreign exchange markets. It is for this reason that, in the medium term, a move to fixed exchange rates remains attractive (and which — given the problems of speculators — means that eventually a single currency may make sense).

Second, and perhaps more fundamentally, some see the demise of ERM as smashing apart the existing consensus and believe it opens up avenues to a return to AES style policies. A recent paper claimed that the infamous French expansion in one country experiment was in fact a success so that the idea of active, expansionary Keynesianism in one country is not a blocked off route (Halimi et al., 1993). Meanwhile increasingly open talk of protectionism is being heard on the left. This often picks up on the rather mild theories of managed trade emanating from the USA or is based on a desire to protect the environment and/or help the third world (see Hines and Lang, 1993). This trend is dangerous. Constructive and imaginative use of protection, for instance to help infant industries and protect R&D investment, is in danger of giving way to policies that simply use protectionism to prop up inefficient industries and to keep prices high. It is also highly questionable that the third world gains from protectionism, either by the West as the CAP shows, or for themselves.

Conclusion

Without hitching oneself to a belief that macro policy is useless, especially at the current time, and that counter-cyclical policy should not be used (Corry, 1993; Wren-Lewis, 1993), we surely do have to go for a strategy that puts supply at its centre with Keynesian policies only as a support. We live in an international capitalist world: not only can we not shut the doors easily, but siege economies have as many drawbacks as they do advantages. We need more managed exchange rates and should look forward to a viable ERM to try and clamber back on board. In this world, the private sector is the key: incentives to get them to act in the public interest and so overcome the impacts of market failure are of course needed, and macro policy should be used to support this whenever possible. But in general it is clear that stability is what is needed for investment, for long-term thinking and confidence in the better welfare of all. The competitiveness of Britain and of Europe depends on these issues.

Notes

Attempts to push non-macro issues were made in the 1970s particularly while Labour was in opposition. However, it never added up to much. 'This failure [of industrial policy] is the more piquant for the fact that whatever the defects of its prescription, the diagnosis of the problems by the left in the policy statements issued in opposition at least had the merit of recognising that British economic problems are more deep-seated than can be treated simply by tricks from the demand-management toolbox.' However, 'In other areas of policy that are nowadays identified as "supply side", the Labour Government did relatively little' (Artis and Cobham, 1991).

It is, however, important to note that many on the more extreme left saw the AES as going far beyond Keynesianism — 'a break with capitalist forms of economic control' (CSE, 1980).

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About the authors

Dan Corry is Chief Executive of New Philanthropy Capital. He was an economic advisor to the Labour Party in the 1990s and worked for the Labour governments of 1997-2010 in the DTI, Treasury and Downing Street.